ECON2131/6034 Public Sector Economics
Tutorial 3
Welfare economics: Efficiency and equity
1. Discuss. For each of the following policy changes, explain why the change is or is not likely to be a Pareto improvement:
(a) Protecting the automobile industry from cheap foreign imports by imposing quotas on the importation of foreign cars.
(b) Increasing social security benefits, financed by an increase in the payroll tax.
(c) Replacing the primary reliance at the local level on the property tax with state revenues obtained from an income tax.
2. True or false. “Utilitarianism implies that a dollar given to one person is as important as a dollar given to anyone else.” Justify your answer.
3. Consider an individual with income I who consumes two goods x andy, with prices px and py respectively. If the individual has Cobb-Douglas preferences, then the indirect utility function and the expenditure function are given by:
where U stands for a given level of utility. Assume that initially I=16, px =1, and py =4. Use the information provided to compute the compensating variation (CV) and the equivalent variation (EV) for an increase in px from 1 to 4.
4. We have shown how the welfare costs of changes in a single price can be measured using compensated demand curves. This problem asks you to generalize this to price changes in two (or many) goods.
(a) A way to show these welfare costs graphically would be to use the compensated demand curves for goods x andy by assuming that one price rises before the other. Provide the graphical illustration for the compensating variation for two alternative assumptions: (1) px increases first and py increases next; (2) py increases first and px increases next. Make sure to include all relevant labels
(b) Use the formal expression for the compensating variation (i.e. CV written in term of expenditure functions) to show that the order in which the price changes are considered does not matter.